Internal Capital Markets in Business...

Internal Capital Markets in Business Groups

Krislert Samphantharak∗

November, 2002

Abstract

Business groups are important in many countries. Several studies have looked at the perfor-mance and behavior of firms that are members of a business group. This paper looks at the issuein more detail and tries to answer some related questions. First, do business groups really haveinternal capital markets and do they provide efficient resource allocation (in a view of the con-trolling shareholders)? Also, what are the characteristics that determine the tendency to haveefficient resource allocation in business groups? Using an investment model with costly externalfinance, I derive an empirical regression counterpart and use it to test the existence of internalcapital markets in business groups. I also test various characteristics of groups that tend toaffect the groups’ resource allocation. Firm-level data from Thailand’s Ministry of Commerce isused as a sample in the empirical sections. The results show that corporate control, group size,and within-group intermediaries tend to facilitate the efficient resource allocation. Corporatelaws and regulations deliver the opposite results while industry diversification shows no effecton within-group resource allocation. In sum, the paper provides evidence from micro data thatthe structure of business groups and corporate governance are related to the investment decisionof firms.

1 Introduction

“Business groups” are common in many countries, especially in emerging economies. In thoseeconomies, the role of collections of legally distinct firms tied together and coordinating on theiractions is important. Linkage between member firms is complex. It could be formal or informal,and direct or indirect — ranging from pyramidal holding company structure to cross ownership andto common directorates. This feature can be traced at least back to the Japanese pre-war zaibutsuand its post-war keiretsu. Many economists have been studying the performance and behaviorof firms in business groups extensively. Several results of those studies refer to the existence ofinternal capital markets within business groups. In this paper, I look at the issue in more detailand try to answer related questions: First, do business groups have internal capital markets? Arethe internal capital markets deliver the efficient resource allocation within the group? Finally, ifsome groups tend to have more efficient allocation than others, what are the characteristics thatdetermine this tendency? Using the firm-level data from Thailand’s Ministry of Commerce, thisstudy shows that the degree of efficiency of resource allocation varies across business groups. Groups

∗Department of Economics, The University of Chicago. 1126 E.59th Street, Chicago, IL 60637. E-mail: [email protected] version is very preliminary and incomplete. Please do not circulate.

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whose controllers have higher control, groups with more number of member firms, and groups withwinthin-group intermediaries tend to have more efficient resource allocation. Groups with largerfraction of listed firms deliver the opposite results while industry diversification seems not to affectthe efficiency of resource allocation of the groups.

In this paper, I define “business group” as a collection of legally independent firms that arewholly or partly owned and managed by the same person (or a group of person such as family)1.What makes business groups different from a collection of firms interacting through the externalmarkets; and what makes business groups different from a collection of segments in a diversifiedfirm? These questions are not new. They are just a variant of what Ronald Coase (1937) posedmore than 60 years ago on the nature of firms and markets. Business groups stand between thetwo of them. I take as a building block Grossman and Hart’s (1986) view of a firm as a nexus ofassets, and use their definition of ownership to distinguish activities within business groups fromthe ones that occur within firms or in the external markets. Grossman and Hart define ownershipas residual control rights over the use of assets of the firms. Therefore, an owner of a firm has aright to transfer assets across segments of the firms in order to maximize the value of her firm. Ineffect, this is just an establishment of internal capital markets within the firm2. Similarly, I definea business group as a collection of legally independent firms that are controlled by a person (or agroup of persons) that has a right over the use of assets of the member firms. This person has aright to transfer assets across the member firms, hence establishing internal capital markets3 withina group. What makes a business group different from a firm is that the right over the use of assetsis limited because each member firm in a group is independent by law. Since the composition ofshareholders of each member firms of a group could be different, the optimal resource allocationin a view of the controller is possibly not the optimal one in other shareholders’ prospect. Thisconflict of interest between inside (controlling) and outside (non-controlling) shareholders makes thewithin-group capital markets imperfect, even when there is no agency problem between the ownerand the managers of the member firms. The degree of imperfection is lower when the controllerhas higher ability to control the group. This ability in turn depends on the structure of the groupand corporate laws in the economy.

I assume that external capital market is imperfect so external fund is more costly than internalfinance. This assumption is natural in emerging economies because their capital markets are notfully developed and firms tend to have credit constraints. As presented in Gilchrist and Himmelberg(1998), the marginal cost of fund determines the firm’s discount factor that is used in discountingthe stream of marginal future benefits of the current investment. As a result, the firm’s investmentwill depend on its financial determinants as well as its profitability. Since a group with absolutecontrol can freely transfer resources across its member firms, the efficient allocation implies thatthe marginal costs of fund are equalized across firms within the group; therefore, a group firm’sinvestment should depend only on its group’s financial factor and the firm’s own profitability— but

1With this definition, I will use the terms “manager” and “controller” interchangeably throughout the paper.2However, the fact that the owner has a full right in asset relocation within her firm does not imply that the internal

capital market is perfect in a sense that it equates marginal product across projects within the firm. Imperfectioncan arise, for instance, in the presence of agency problem between the owner and the managers of different segments.See Stein (1997) and Rajan, Servaes and Zingales (2000).

3Here I use the term “internal capital market” in a very broad meaning. It includes within-group transfers,within-group credit markets, and within-group equity market, among others.

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not the firm’s financial determinants.In this paper, I will study the issue addressed above in two steps. First, I derive two structural

models of investment in the presence of costly external finance— one for a non-group firm andthe other for firms in a group with absolute control. I derive an empirical counterpart of themodel and use it to test whether there is internal capital markets in groups or not, and alsowhether they deliver an efficient resource allocation outcome. Then, I test which characteristicof groups that affect the efficiency of resource allocation. The potential characteristics includecorporate ownership and control of the groups, group size, corporate law and regulation, within-group intermediaries, and industry diversification. The results show that (1) corporate control, (2)group size, and (3) within-group intermediaries tend to facilitate the efficient resource allocation ina view of the controlling shareholders. Corporate laws and regulations deliver the opposite resultswhile industry diversification shows no effect on within-group resource allocation. In sum, the paperprovides evidence from micro data that the structure of business groups and corporate governanceare related to the investment decision of firms.

Before going to the next sections, it is important to address three issues explicitly. First,the main purpose of this paper is not to propose a theory explaining the formation of businessgroups and I will take the existence of business groups as well as groups’ characteristics as given.However, the results from this paper should suggest some ideas on the nature of business groupsthat motivate a future research on endogenous group formation and endogenous group structure.Second, modeling the costly external finance is beyond the scope of this paper. Cost of externalfinance is assume to be increasing and convex a priori. Lastly, with the existence of costly externalfinance, I define efficient resource allocation as the allocation of fund that equalizes the marginalcost of external finance across firms in a group. If the marginal costs are not equal, the controllercan get higher aggregate profit from transfering fund from the firms with low marginal costs to thefirms with higher marginal costs. Therefore, the term “efficiency” in this paper is defined in a viewof the controller.

The rest of the paper goes as follows. Section 2 reviews related literature regarding capitalmarkets and corporate investment, as well as existing studies on business groups. Section 3 presentsthe structural model of corporate investment of non-group and group firms when external fund iscostly. Section 4 presents an empirical strategy of this study. Section 5 describes Thailand’s firm-level data and reasons why this data set is good for this study. The empirical results are in section6. The paper ends with conclusion and appendix.

2 Related Literature

How to allocate funds across projects is a fundamental question in corporate finance. The existingliterature looks at two similar but different questions on this issue. The first question is how toallocate funds across firms in the economy, and the second one is how to allocate funds acrossprojects within a particular firm. In other words, the first question concerns with external capitalmarket while the second question looks at the internal market. Stein (2001) offers a more extensivesurvey of the literature in this field.

External Capital Market and Investment

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I start with the literature on external capital markets. In their seminal paper, Modigliani andMiller (1958) show that, in a world with frictionless perfect capital markets, capital is allocatedefficiently in such a way that the marginal product of capital is equated across all projects in theeconomy. The Q-theory approach, proposed by Tobin (1969) and extended by Hayashi (1982),reformulates the neoclassical theory of investment with the implication that, under perfect capitalmarket, a firm’s investment should depend only on its profitability, as measured by the Q value.Firm’s financial characteristics such as capital structure or liquidity should not affect the firm’sinvestment behavior.

However, in a world with frictions such as information asymmetry, internal and external financeare not perfect substitutes. Using funds from external sources is possibly more costly than usinginternal funds such as cash flow. For example, Myers and Majluf (1984) and Greenwald, Stiglitzand Weiss (1984) suggest that issuing new equities could be costly to the firm; Stiglitz and Weiss(1981) show that some firms with good investment opportunity cannot get loans to finance theirprojects.

Studies of the effects of financing constraints on corporate investment can be traced back atleast to Meyer and Kuh (1957) and have been growing since the work by Fazzari, Hubbard andPeterson (1988). The empirical strategy goes as follows. First, sample firms are divided into groupsa priori according to their degree of credit constraint. The criteria range from dividend payouts(Fazzari, Hubbard and Peterson (1988)) to membership in large industrial groups (Hoshi, Kashyapand Scharfstein (1991) for Japanese keiretsu, Perotti and Gelfer (1998) for Russian Financial-Industrial Groups, among others). Running a regression of a firm’s investment on its cash flowand some measures of its future profitability, these studies then compare the regression coefficientsof the cash flow from different groups of firms. The common finding is that the investment ofthe firms that are a priori group as credit-constrained firms is more sensitive to cash flow thanthe one of unconstrained firms. The argument from this investment-cash flow regression is thata credit-constrained firm has to rely more on its own internal fund; therefore, its investment ismore sensitive to the movement of its cash flow4. However, this investment-cash flow approach iscriticized by Kaplan and Zingales (1997, 2000) that the firms with higher sensitivity of investmentto cash flow empirically are not necessary the firms with higher degree of credit constraint5.

Although most of the empirical research in this field mainly focus on testing the implicationof the theory, there are also some studies that try to estimate the structural model of corporateinvestment and financial policy. Bond and Meghir (1994) investigate the relationship betweeninvestment and cash flow by estimating the Euler equation for optimal capital accumulation inthe presence of convex adjustment costs. Gilchrist and Himmelberg (1998) post and try to answera slightly different question: How much does investment respond to its “fundamental” versus“financial” determinants? In sum, their study shows that, in addition to a firm’s fundamentalprofitability, financial factors help explain the firm’s investment.

Internal Capital Market and InvestmentTheoretical ideas about capital markets within a firm date back to at least Alchian (1969)4Hubbard (1998) offers a survey of the literature in this direction.5Kaplan and Zingales (1997) re-categorize low-dividend firms in Fazzari, Hubbard and Peterson’s sample according

to each firm’s annual report and management discussion of liquidity. They find that firms that appear financially lessconstrained have higher investment sensitivity to cash flow than the firms that appear more constrained.

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and Williamson (1975). Alchian’s argument on the advantage of internal capital market is thatcorporate headquarters have ability in monitoring and information production. However, Gertner,Scharfstein and Stein (1994) argue that Alchian does not give a clear reason why headquarters arebetter than a bank in a delegated monitoring model of Diamond (1984). Instead, in their opinion,the main distinction between a bank and corporate headquarters are that the headquarters ownthe business units while the bank does not. Their definition of ownership follows Grossman andHart (1986) in a sense that it means a residual control rights over the use of assets of the firms.

Examples of empirical studies in this line of research are Lamont (1997) and Shin and Stulz(1998) for conglomerates; and Houston, James and Marcus (1997) for bank holding companies.They find that loan growth at a subsidiary bank is more sensitive to the holding company’s cashflow and capital position than the bank’s own. Their results suggest that there is an internal capitalmarket within a firm, but the market is not perfect.

Business GroupsAn intermediate case of capital allocation applies to business groups6. Most of economics

literature on business groups focuses on the characteristics and roles of Japanese keiretsu7. Thetraditional findings are that the keiretsu firms tend to have lower operating profitability but alsolower variance. The results support the idea that there is insurance within the group, but thisinsurance comes with a cost in terms of lower average profits. Recently, there are studies thatchallenge the traditional idea of insurance provided by keiretsu. See Beason (1998) and Kang andStulz (2000) for examples.

Khanna and Rivkin (2001) studies the performance of group firms in emerging markets. Theirresults on profitability, as measured by the rate of returns to asset, of the firms are diverse: Affiliatedfirms have higher profitability than non-affiliated firms in some countries, while lower or indifferentin other countries. However, profit rates of group firms are closer to one another than they are tothe profit rate of other firms in almost all countries in their sample. Khanna and Yafeh (2000) lookcloser on three channels of risk sharing among business groups. First, they find that there is profitsharing through intra-group trade in some countries, but the magnitude is quite small. Second,they find no evidence supporting that dividend plays a role as shock absorbers. Finally, they findthat within-group loans are associated with substantial liquidity smoothing in India.

Lastly, following a series of recent economic crises, many studies have been focusing more onthe dark side of business groups. One of the main ideas is that business groups are associated with(legal or illegal) minority shareholder expropriation. The insight stems from Akerlof and Romer’s(1993) looting and Johnson, La Porta, Lopez-de-Silanes and Shleifer’s (2000) tunneling. Claessens,Djankov, Fan and Lang (1999) take this idea and look at East Asian crisis, while Bertrand, Mehtaand Mullainathan (2003) focus on Indian groups.

Differences between this Study and Existing LiteratureMost of the literatures on business groups focus on the groups performance as measured by

profit rates. However, profit rate is not a good variable used to analyze the problem of resourceallocation within a group. In production theory, the first-best capital allocation is the allocation

6Business group is a topic studied not only in economics but in sociology as well.7Hoshi and Kashyap (2001) offer extensive survay of this literature.

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that equalizes net8 marginal product of capital across firms in the group. In principle, marginalproduct of capital is observable so we can test the theory of efficient resource allocation directly bycomparing the marginal product across firms. However, capital is a durable good, so the profit rate(or the rate of return to assets) is just a part of a stream of marginal product of capital over thelifetime of that capital good. As a result, equal profit rates at a given date do not imply efficientcapital allocation. Looking jointly at investment and its profitability (such as Q in the neoclassicaltheory, for instance) is preferable. Efficient allocation of capital implies higher investment in aproject that has higher profitability.

Although a lot of work on investment and business groups has been done already, very few ofthem really look at the internal capital market within business groups. The closest study is Hoshi,Kashyap and Scharfstein (1991). However, their study is mainly on the relationship between afirm’s liquidity and its investment, where the existence of internal capital markets within keiretsuare implicitly assumed a priori. Therefore, they focus more on comparing the effect of being in(any) business groups and not being in (any) groups rather than the efficient resource allocation offirms when they are in the same group. The study of interdependence of resource allocation acrossinvestment units is more prominent in Lamont (1997), and Shin and Stulz (1998), but their studieslook at the allocation of capital within a firm — not across firms within a group as what I studyhere. Looking at internal capital markets across firms within a business group has an advantageover looking at the market within a firm in a sense that data on assets, investment, and so on arebetter defined and measured at the firm level than at the segment level, especially when assets suchas buildings or machines are commonly used by more than one segments. On the other hand, onewould argue that transfers across segments of a firm have less friction than transfers across firmswithin a group, in particular when the ownership composition of the firms are different. However,the benefit of this imperfection is that it can then be used to test the implication of corporatecontrol and corporate governance on investment later. Moreover, this paper also look at variouscharacteristics of the groups that tend to efficient resource allocation and empirically test themjointly.

3 Model

The model used in this paper is a corporate investment model with costly external borrowing. Thistype of model has been extensively used in many studies9. For simplicity, the financial friction isnot endogenously modeled in this study. Instead, we assume that if firm i borrows by issuing aone-period corporate bond Bt in period t, it has to repay Ri (Bt) in period t+ 1, where Ri (·) is amonotonically increasing in B and is continuously differentiable with respect to B.

We study investment behavior of two extreme types of firms in this section. The first type isthe firms that do not belong to any business group. The problem of this type of firms is the sameas what was presented by other existing literature. In this case, each firm solves its optimizationproblem individually. The second type of firms is the group firms over which the controller has afull control. Since we define a business group as a collection of firms that are controlled by the same

8Net of marginal cost of capital.9Examples are Whited (1992), Hubbard and Kashyap (1992), Jaramillo, Schiantarelli and Weiss (1996), and

Gilchrist and Himmelberg (1998).

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controller who also owns shares of the group’s member firms, the controller of a group maximizesher own total dividend streams from all firms in the group. Since the controller controls the group’sdecision completely, she can make any internal transfers of fund between the firms in her group.This frictionless transfer within group is not likely to occur if the controller does not have a fullcontrol over all firms in the group. We will discuss the sources of this friction, and empirically testthem later in this paper.

3.1 Non-group Firm

The problem of the controller of a non-group firm is to choose the paths of capital stock and debt soas to maximize her expected discounted dividend stream, subject to constraints on nonnegativityof dividends.

max{Kτ+1,Bτ}∞τ=t

Dt +Et

∞Xs=1

βsDt+s

subject to

Dτ = Π (Kτ )− Iτ −C (Iτ ,Kτ ) +Bτ −R (Bτ−1)Kτ+1 = (1− δ)Kτ + Iτ

Dτ ≥ 0,

for all τ ≥ t, where Π (·) and C (·) are the firm’s production function, and adjustment cost function,respectively; β is a constant discount factor; and δ is a constant depreciation rate of capital stock.

Let λτ be a Lagrange multiplier for non-negative dividend constraint in period τ .

Substituting Iτ = Kτ+1 − (1− δ)Kτ into Dτ ,

Dτ = Π (Kτ )− (Kτ+1 − (1− δ)Kτ )− C (Kτ+1 − (1− δ)Kτ ,Kτ ) +Bτ −R (Bτ−1) .

The first-order condition with respect to Kt+1 is

− (1 + λt)

·1 +

∂C (Kt, It)

∂It

¸+Et

½β (1 + λt+1)

·∂Dt+1∂Kt+1

+ (1− δ)

µ1 +

∂C (Kt+1, It+1)

∂It+1

¶¸¾= 0.

The Euler equation for investment is

1 +∂C (Kt, It)

∂It= Et

½β · 1 + λt+1

1 + λt··∂Dt+1∂Kt+1

+ (1− δ)

µ1 +

∂C (Kt+1, It+1)

∂It+1

¶¸¾. (1)

Note that λt is the shadow price of the firm’s internal funds.The first-order conditions for borrowing imply

Et

·1 + λt+11 + λt

¸· β ·R/ (Bi,t) = 1, (2)

where R/ (Bi,t) ≡ dR(Bi,t)dBi,t

. Equation (2) can be viewed as an asset pricing equation, where β 1+λt+11+λtis the effective stochastic discount factor faced by the firm. The equation implies that the variablesthat raise the marginal cost of borrowing tend to reduce the adjustment coefficient of the expecteddiscount factor , Et

h1+λt+11+λt

i.

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3.2 Group with Full Control

Suppose that a firm belongs to a business group. We assume that this firm has (at least) twosources of external finance, namely from outside its group and from other firms within the group.We want to characterize the efficient allocation of fund within a group. By “efficient allocation”, Imean the allocation that maximize the total value of the shares owned by the group’s controller10.As we shall see later, this efficient allocation may not be the efficient one in a view of outsideshareholders or the economy as a whole.

Since the controller of group firms has a full control over the whole within-group transfercontracts, we can think that in each period τ she can just choose a net group’s transfer ti,τ to eachmember firm i. Note that transfers could be positive or negative. Indeed, it is possible that theyare positive or negative for a particular firm in all periods.

Because a membership of a group and the ability of a group controller to transfer funds withinher group are common knowledge, we assume that if firm i borrows by issuing a one-period corporatebond Bi,t in period t, it has to repay R i (Bi,t,BI,t) in period t+1, where Ri (·) is a monotonicallyincreasing in Bi,t and each element of BI,t and is continuously differentiable with respect to Bi,tand BI,t. Note that BI,t is a vector of borrowing of each firm in group I, i ∈ I.

The controller’s problem is

max{Ki,τ+1,Bi,τ ,ti,τ}∞τ=t

NIXi=1

θi

"Di,t +Et

∞Xs=1

βsiDi,t+s

#

subject to

Di,τ = Πi (Ki,τ )− Ii,τ − Ci (Ii,τ ,Ki,τ ) + ti,τ +Bi,τ+1 −Ri (Bi,τ ,BI,τ )Ki,τ+1 = (1− δi)Ki,τ + Ii,τ

θiDi,τ ≥ 0

NIXi=1

ti,τ = 0,

for all τ ≥ t, where θi is the controller’s share in firm i.Let λi,t denote the Lagrange multipliers of the dividend nonnegativity constraint of firm i, and

µt be the multiplier for the break-even condition of the group’s transfers in period t, respectively.The Euler equation for investment is the same as equation (1).

The first-order conditions for external borrowing imply

Et

·1 + λi,t+11 + λi,t

¸· βi ·

dR (Bi,t,BI,τ )

dBi,t= 1, for all i, (3)

10 In this paper, a composition of a group is exogenously given in two ways. First, whether a firm belong to anygroup is given. Also, the number of shares of group firms held by the manager is also exogenous. Endogenizinggroup formation is an interesting research, but it is beyond the scope of this paper. However, I will later discuss howselection and endogenous share-holding affect the empirical findings.

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wheredR(Bi,t,BI,τ)

dBi,tis the total derivative of R (Bi,t,BI,τ ) with respect to Bi,t. Again, the effective

stochastic discount factor is 1+λi,t+11+λi,tβi. Finally, the first-order conditions for internal transfers imply

Et

·1 + λi,t+11 + λi,t

¸· βi = Et

·µt+1µt

¸, for all i. (4)

Since all firms in the group are facing the same shadow price of within-group transfers µ, equation(4) implies that Et

h1+λi,t+11+λi,t

iβi is the same for all firms in the group. This is intuitive because

this condition further implies that the marginal cost of external borrowing is equalized across

firms within the same group, i.e.dR(Bi,t,BI,τ)

dBi,t= 1

Ethµt+1µt

i . Since the controller can transfer fundfrictionlessly within the group, the optimal borrowing pattern is that all firms in the group borrowuntil their marginal costs are equal, which is also equal to the group’s shadow internal interest rate.

This case illustrates at least two effects of a group on a member firm’s behavior. First, thereis insurance across firms within a group. Idiosyncratic shocks to a firm’s internal sources of fundsuch as cash flows are absorbed by the whole group through within-group transfers. Therefore, inthis extreme case, we would expect to see no effect of firm’s financial idiosyncratic shocks on itsinvestment. The second effect is a tunneling effect. The firms with lower costs of external borrowingbehave like a credit supplier to the firms with higher costs. The “donor” firms cannot use that fundto invest in its own projects. This effect could lead to a conflict of interest between controlling andnon-controlling shareholders. The conflict is minimal when the compositions of shareholders areidentical for all members of the group. In such case, the group itself is equivalent to a diversifiedfirm, where each member firm is considered as its segment.

It is not so obvious to say that being in a group hurts the monority shareholders. First, asdescribed above, being in business group could serve as an insurance device for member firms,which may benefit the controlling shareholder as well as the minority shareholders. Second, beinga member in business groups is a common knowledge so the minority shareholders are likely to takethis information into their consideration when they made their decision to purchase the share ofthe firm. One implication is that the stock price has incorporated this information already. Also, ifwe observe that there are minority shareholders holding shares of the firms, it must be that doingso benefits them in some ways. In other words, even though the non-controlling shareholders knowthat the controller may transfer funds out of the firm, holding some shares of the group firm couldbe the optimal portfolio choice of the non-controlling shareholders. To perform welfare analysis, weneed to know the preference of both controlling and non-controlling shareholders. This is beyondthe scope of this paper.

As a final remark, although the ownership parameter θi does not directly affect either investmentdecision or financing decision of a particular firm, it does indirectly affect investment and financing

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decision of the firm through the value of µt and µt+1,

µt =

NIPi=1

θi (1 + λi,t)

NI=

NIPi=1

θi (1 + λi,t)

NIPi=1

θi

·

NIPi=1

θi

NI,

µt+1 =

NIPi=1Et [θi (1 + λi,t+1)βi]

NI=

NIPi=1Et [θi (1 + λi,t+1)βi]

NIPi=1

θi

·

NIPi=1

θi

NI.

In other words, the group’s shadow price of internal fund is a product of a weighted average of themember firms’ shadow price of internal fund and an average of the shares owned by the controller.

3.3 Frictions within Group

In the real world, a controller of a group rarely have full control over the member firms. I considersome frictions that affect the likelihood that a group will have efficient allocation (in a perspectiveof a controller) in this section.

3.3.1 Controlling Ability of the Controller

As discussed above, although a business group provides some insurance across firms within thegroup, it could have tunneling effect as well. Since this tunneling has negative impacts on outsideshareholders of the donors while it has positive effects on outside shareholder of the recipient firms,there is a tension between inside (controlling) and outside (non-controlling) shareholders. We wouldexpect that a group over which its controller has more “control”, such as measured by ownershipor voting rights, is more likely to have efficient allocation. It is important to note that not onlycontrol over a particular firm matters for the firm’s investment, the control over the other firms inthe group also determines the existence of internal capital markets. In other words, the fact thata controller has absolute control over a particular firm does not guarantee perfect internal capitalmarket outcomes. To have such outcomes, the controller needs to have absolute control over otherfirms in the group as well.

3.3.2 Corporate Law and Regulation

Usually minority shareholders’ interest is protected by corporate laws, although the degree ofprotection varies by countries and legal systems11. Within a country level, different types of firmscould be governed by different laws, which have different restrictions and requirements on transfersand loans among firms within a group12. A group consisting of many strictly-regulated firms is lesslikely to have efficient resource allocation since their resource transfers are more difficult.11La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998) have a cross-country survey on this issue.12See example for Thailand in the empirical sections.

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3.3.3 Within-Group Intermediaries

As a knowledge in banking theory, intermediaries facilitate flows of funds across economic units. Inthe context of business groups, intermediaries include financial intermediaries (commercial banks,finance companies, and insurance companies, among others), as well as firms that act as the vertexof the pyramidal structure of the groups such as holding companies. Therefore, groups with financialintermediaries are more likely to have efficient resource allocation.

3.3.4 Industry Diversification

Traditional wisdon suggests that industry diversification provides insurance against a group’s ag-gregate shocks, i.e. the more diversified the group, the less volatile the group’s cash flow. However,this argument does not imply how resources are allocated across member firms, given the aggregateshocks to the group. In practice, both industry homogeneity and diversity could facilitate flows ofresource across firms. For example, two member firms could trade between themselves on credit, inaddition to direct lending or borrowing in cash13. This creates one kind of internal credit market.Within-group trade could be both intra-industry or inter-industry, depending on the nature of thegroup itself. For example, a frozen chicken firm could buy raw chicken from a chicken farm ownedby the same controlling shareholders. On the other hand, trading within group could be inter-industry. For instance, a department store could buy canned food or clothes from it’s affiliatedfirms.

3.3.5 Size of Group

In principle, size of the groups can have either positive and negative effect on the group’s likelihoodof having efficient resource allocation. On one hand, bigger groups are more likely to have moresevere within-group information and coordination problems, hence less likely to deliver perfectinternal capital market outcome. On the other hand, groups with more members are more likely tohave alternative ways to transfer resources among themselves14, thereby tending to have efficientresource allocation.

4 Empirical Strategy

To derive the regression specification, we follow the method used by Gilchrist and Himmelberg(1998). First, we recursively substitute the investment Euler equation (1) to get

1 + c (Ii,t,Ki,t) = βiEt

∞Xs=1

βs−1i (1− δi)s−1

ÃsYk=1

µ1 + λi,t+k1 + λi,t+k−1

¶!MPKi,t+s, (5)

13Other related examples along this line include (1) transfer of physical capital such as machine between firms thatproduce similar goods (hence using similar type of machines); (2) transfer pricing by setting the price of product soldto affiliated firms lower than the market price.14For example, suppose that a group has two firms (firm A and firm B), and the controller is prevented to transfer

resources explicitly across these firms. It is unlikely that the group will have efficient resource allocation. However, ifthis group has firm A, firm B, and firm C, where firm C does a business with both firm A and firm B. It is possible forthe group to transfer resources indirectly between firm A and firm B — through the channel provided by transactionswith firm C.

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where c (Ii,t,Ki,t) is the marginal adjustment cost and MPKi,t is the marginal profit net of adjust-ment costs, i.e. MPKi,t =

∂D(Kt)∂Kt

= ∂Π(Kt)∂Kt

− ∂C(It,Kt)∂Kt

.

With assumptions (i) that 1+λi,t+k1+λi,t+k−1 linearly depends on firm’s financial characteristics FINi,t+k

if firm i is a non-group firm, and depends on a group-time financial determinant FINJt+k, where J

is a group index, if firm i is in group J ; (ii) that the adjustment cost is quadratic in Ii,tKi,t

, i.e. its

marginal cost is linear in Ii,tKi,t

. Derivation in the appendix shows that we can linearly approximateequation (5) as

Ii,tKi,t

=

α0 + fi + α1Q

FINi,t + α3Q

MPKi,t + εi,t, if firm i is non-group firm

α0 + fi + αJ2QFIN,Jt + α3Q

MPKi,t + εi,t, if firm i is in group J ,

(6)

where QFINi,t is the present value of financial characteristic that determine the marginal cost of

external finance of firm i; QFIN,Jt is the present value of financial characteristic that determinethe marginal cost of external finance of member firms in group J ; and QMPKi,t is the present valueof the marginal profitability of investment of firm i in period t. This equation shows that, in apresence of imperfect capital market, a firm’s investment depends on its cost of financing (QFINi,t

and/or QFIN,Jt ), in addition to its investment profitability and the firm’s fixed effect.To get an implementable regression equation, I rewrite equation (6) as

Ii,tKi,t

= α0 + fi + α1QFINi,t +

NXJ=1

¡γJ0,td

Ji,t + γJ1,td

Ji,tQ

FINi,t

¢+ α3Q

MPKi,t + εi,t; E [εi,t] = 0. (7)

where dJi,t is a dummy variable indicating that the firm is in group J in period t. For a non-groupfirm, dJi,t = 0 for all J ; therefore, its investment depends on its own financial situation captured byQFINi,t and its investment profitability measured by QMPKi,t , in addition to the firm characteristiceffect fi. For a firm in group I, dJi,t = 0 for all J 6= I. If the group is fully controlled and capitalis allocated efficiently across firms within the group, then we expect to see α1 + γJ1,t = 0. Equation(7) is the regression specification counterpart of the model that we will use in the empirical part ofthis study.

If QMPKi,t is a true state variable and is correctly measured, then the existence of perfect internalcapital markets15 implies that a group firm’s investment decision should be independent of the firm’sfinancial characteristics, after being controlled for its group effect. Therefore the null hypothesis ofhaving perfect internal capital markets is that

H0 : α1 + γI1 = 0.

However, there are several frictions that make internal capital markets imperfect. To test theextent that each factor affects the within-group resource allocation, I modify equation (7) to get afollowing regression specification:

Ii,tKi,t

= α0 + fi + α1QFINi,t +

NXJ=1

γJ0,tdJi,t +Q

FINi,t Xiη + α3Q

MPKi,t + εi,t; E [εi,t] = 0, (8)

15 In a sence that fund is allocated efficiently.

12

where Xi is a matrix of characteristics of firm i or group I to which firm i belongs, i ∈ I, andη is a corresponding vector of coefficients. If an element of η has a negative coefficient, thecharacteristic makes investment less sensitive to the firm’s own financial characteristics. On theother hand, if an element of η has positive, the characteristic makes investment more sensitive tothe firm’s own financial characteristics. Note that the dummies dJi,t capture the common group’sfinancial characteristics. We expect that the characteristics facilitating the operation of internalcapital markets should have negative coefficients, and opposite result for the characteristics thatprohibiting the internal capital market.

5 Data

5.1 Data Source

The sample used in this study are some listed and some non-listed firms in Thailand during 1993-1996. There are several reasons why the data for Thailand over that period is a good sample in thisstudy. First, it was an emerging economy that capital markets were not fully developed. Second,business groups were in essentially every sectors. Moreover, we can extend the period of the dataset to study the response of groups to shocks during the 1997 economic crisis. Finally, the datais available for both listed and non-listed firms. Therefore, we can test the effect of corporate lawand regulation on the investment decision of firms as well.

I exclude all firms in financial and real estate sectors from the sample because the interpretationof their financial balance sheets is different from firms in other sectors. The sample consists of abalanced panel of 907 firms from 1993 to 1996. All firms in the sample are relatively big firms inThailand during the period covered in the data. For every year during 1993-1996, either (1) theyhad annual turnover more than 200 million Baht16; (2) they were one of the leading companies inits industry; or (3) they were listed in the Stock Exchange of Thailand. Totally, there are 2,721firm-years in the full sample. Some observations are dropped out later due to missing values ofsome variables.

5.1.1 Financial and Ownership Data

All registered firms17 in Thailand have to submit annual financial statements to the Ministry ofCommerce. The documents submitted must be audited by authorized accounting auditors. Thedata are publicly available upon paying some fee. Moreover, all listed firms are also required tosubmit the same as well as additional data to the Security and Exchange Commission.

5.1.2 Data on Groups

Groups are defined on ownership and control basis — Firms are in the same group if they are (whollyor partly) owned and managed by the same family. To identify groups, I firstly use the informationfrom a book called Thai Business Groups 2001: A Unique Guide to Who Owns What. There are16Approximately 8 million US Dollar using 1996 exchange rate, or 4.44 million US Dollar using 2002 exchange rate.17By “registered firms”, I do not consider all small informal household business, such as a noodle shop or a street

vendor because they are not juristic person under Thailand’s Civil and Commercial Code.

13

150 families covered in the book. Although the book provides a lot of information about familybackgrounds, its list of companies affiliated to each family cannot serve the purpose of this studywell. For example, some particular firms were considered as an affiliation to several groups. Somecompanies were assigned to a family even though the family did not hold so many shares in thecompanies when I check with the corresponding ownership data from the Ministry of Commerce.Also, some families are so tied together that we cannot consider them separately. Finally, there werea lot of groups that were not included in the book due to their small number of member firms, eventhough each member firm was considered large and important in its industry. Therefore, I focusmainly on the ownership data from the Ministry of Commerce and identify group firms by myself,with some helps from the book as sometimes family members do not share the same lastname. Insum, 117 groups are included in the current sample — 27 of them are additional to the ones listedin the book. Figures 1 to 3 present some examples of groups.

Figure 1 Examples of Simple Group Structures

Figure 1 shows example of simple group structures. Figure 1A presents a group that consists ofmany firms owned by the same family. There is no direct connection between the firms themselves.Alternatively, figure 1B shows a group formed by a chain shareholding. Figure 1C is an example of apyramidal structure of business group. Finally, figure 1D presents a group with cross shareholding.

14

Business groups may have a more complex structure than the ones shown in figure 1. A groupmay consist of many chain shareholdings or many firms serving as a vertex of a pyramidal structure.Cross shareholding could also be more complex. Figures 2 and 3 show examples of more complicatedgroup structures. To avoid confusion, all numbers indicating shareholding are not included.

Figure 2 Example of Groups with Many Chain Shareholding and Many Pyramids

15

Figure 3 Example of Groups with Many Chain Shareholdings, Many Cross Shareholdings andMany Pyramids

5.2 Data Description and Summary Statistics

5.2.1 Firm Characteristics

Tables 1 and 2 present summary statistics of the firms in the sample. In this paper, industry isclassified in 2 levels. The broad classification consists of 8 industries while the detailed classificationhas 41 industries. After excluding financial and real estate sectors from the sample, there are 34industries in 7 broad categories. The summary statistics for each industry are shown in table 1.Table 2 provides summary statistics of financial characteristics of firms in the sample.

16

17

Table 1 Summary Statistics for Industries in the Sample Number of Firms Age in 1996 (Year)

Industry Total Listed Firms

Public Firms

Group Firms Mean Min Max Med

Std. Dev.

Agriculture 130 27 27 84 18.5 4 54 17 10.0 Farming, Livestock, Fishery & Aquaculture 11 1 1 11 18.1 8 23 18 5.5 Animal Feeds 19 7 7 17 15.8 6 29 17 7.4 Agriculture Product from Crops 60 7 7 34 22.3 5 54 22 11.9 Agriculture Product from Animals 24 10 10 10 13.1 4 24 12.5 5.1 Agriculture Related Business 16 2 2 12 16.0 5 31 16 7.9 Consumer Products 158 27 27 80 26.4 3 114 24 17.3 Foods 50 14 14 20 22.7 6 46 21.5 9.9 Beverages 22 3 3 20 22.3 7 63 13.5 14.7 Pharmaceuticals & Cosmetics 34 3 3 10 27.7 4 105 26 15.9 Consumer Items 15 2 2 5 34.1 8 114 29 26.8 Department & Grocery Stores 12 1 1 10 15.8 3 28 17 7.6 General Trading 25 4 4 15 35.8 11 112 28 23.3 Financial Institutions 107 59 71 37 31.5 4 90 26 16.8 Banking* 18 13 16 8 48.6 9 90 50 16.3 Securities & Trusts* 41 26 34 9 24.4 4 44 24 6.2 Insurance* 22 14 14 8 47.6 18 67 48 11.1 Financial Services* 14 3 4 2 20.1 11 60 16 13.2 Venture Capitalist* 12 3 3 10 13.2 10 24 12.5 3.7 Services 90 27 29 36 20.3 4 120 18 15.7 Transportation & Delivery Services 29 4 4 6 23.4 5 65 23.5 16.4 Hotels, Restaurants & Tours 33 13 14 17 20.5 7 120 13 20.0 Hospitals & Clinics 10 6 6 1 17.7 10 25 18.5 4.2 Other Services 18 4 5 12 16.8 4 29 16.5 8.1 Light Industry 258 86 86 114 17.9 3 50 16 9.8 Textiles, Garments, Accessories & Leather Products 59 25 25 30 21.6 6 43 22 8.6 Jewelry & Ornament 13 5 5 2 12.6 3 24 11 7.7 Footwear, Sport Goods & Toys 13 3 3 10 16.5 8 46 12 12.9 Paper, Paper Products, Books & Stationery 29 5 5 10 16.5 6 28 15 7.0 Glass & Glassware 13 3 3 9 18.9 5 45 17 11.0 Electrical & Electronic Products 46 15 15 13 18.7 5 44 16 9.7 Wood Products & Furniture 10 3 3 3 16.0 9 24 15 5.1 Rubber Products 13 5 5 7 19.7 6 48 19 12.9 Printing & Publishing 12 8 8 4 23.3 6 50 22.5 12.6 Computers, Telecommunications & Office Equipment 39 13 13 24 13.4 3 43 10 8.7 Other Light Industry 11 1 1 2 15.2 4 29 9 10.5

18

Table 1 (Continued) Summary Statistics for Industries in the Sample Number of Firms Age in 1996 (Year)

Industry Total Listed Public Group Mean Min Max Med Std Dev

Heavy Industry 138 23 24 58 20.2 3 50 19 10.8 Mining, Quarrying, Iron, Steel & Non-Ferrous 32 8 8 15 20.0 3 38 18.5 10.6 Petroleum, Gas & Exploration Services 18 6 7 7 21.8 7 50 20 13.6 Machinery & Equipment 19 2 2 10 19.9 5 49 20 13.0 Other Metal Fabricated Products 15 5 5 3 21.9 6 38 23.5 9.1 Automobiles, Motorcycles, Trucks, Tractors, Spare Parts 54 2 2 23 19.4 4 46 18 10.0 Chemical & Petrochemical Products 75 16 17 35 17.3 3 37 16 9.0 Chemicals & Paints 51 5 6 21 17.6 3 37 16 9.4 Plastics 24 11 11 14 16.7 6 33 13.5 8.3 Construction and Real Estate 84 47 51 50 22.3 3 83 21.5 13.9 Construction Contractors & Consultants 29 9 10 11 23.2 8 66 22 12.4 Real Estate Developers* 26 22 25 16 11.5 7 16 11.5 6.4 Construction Material 29 16 16 23 22.1 3 83 21 15.5 All 1040 312 332 494 21.5 3 120 18.5 13.7 Sample* 907 231 236 441 20.3 3 120 18 12.8 * Sample excludes Real Estate Developers and Financial Institutions.

19

Table 2 Summary Statistics for Financial Characteristics

Sample All Firms Group Firms Non-Group Firms

Total Assets (Million Baht) Mean 3,491 5,731 1,333 Min 7 22 7 Max 2,420,000 2,420,000 39,000 Median 846 1,076 684 Standard Deviation 60,800 86,800 2,269

Total Fixed Capital (Million Baht) (1) Mean 687 915 467 Min 0.06 0.06 0.10 Max 45,200 45,200 9,964 Median 207 240 179 Standard Deviation 2,218 3,029 854

Age (Year) Mean 19.54 19.35 19.72 Min 0 0 0 Max 120 105 120 Median 18 17 18 Standard Deviation 12.31 11.85 12.73

Investment Rate (2) Mean 0.122 0.113 0.132 Min -0.989 -0.973 -0.989 Max 1.937 1.937 1.888 Median 0.020 0.006 0.036 Standard Deviation 0.386 0.405 0.366

Cash Flow to Capital Ratio (3) Mean 0.206 0.191 0.220 Min -0.213 -0.206 -0.213 Max 0.934 0.934 0.923 Median 0.161 0.149 0.173 Standard Deviation 0.178 0.170 0.184

Profit Rate (4) Mean 0.041 0.042 0.040 Min -0.472 -0.352 -0.472 Max 0.541 0.525 0.541 Median 0.027 0.027 0.027 Standard Deviation 0.086 0.086 0.086

Remarks: (1) Total fixed capital includes land and machinery and excludes all financial assets such as cash, loans or investment in securities. (2) Investment rate is the rate of change in total fixed investment. (3) Cash flow to fixed capital. (4) Profit rate is total net profit to total asset ratio.

There are various legal types of business organizations in Thailand. I do not consider soleproprietor18 and non-registered partnership19 in this study since they are not juristic person underThai laws. Thai corporate laws allow Thai company be registered in only two types: privatelimited company20 and public limited company. Shareholders of private limited company enjoylimited rights or protections under the Civil and Commercial Code. On the other hand, publiclimited company is governed by the specific law called Public Limited Company Act B.E. 2535(A.D. 1992). The law was drafted with a view to revamp the old Public Limited Company ActB.E. 2521 (A.D. 1978) which was obsolete and impractical. The features in the current law thatgive more protection to minority shareholders are that21:

- (80) A director that benefits from purchases of sales of the company’s assets cannot votefor or against the transactions.

- (86) A director is prohibited from operating the same business that competes with thecompany, unless she announces that she is doing such a business during the shareholder meetingbefore appointed.

- (87) A director cannot purchase assets from or sell assets to the company, unless theboard of directors approves the transaction.

- (88) A director must inform the company whenever she benefits from any contracts madeby the company.

- (89) A public limited company cannot lend to (or put a collateral for) its directors oremployees (or any businesses owned more than 50% by its directors or employees), except that thelending is classified as a welfare compensation or it is a business as usual for commercial banks.

Additionally, under the Stock Exchange of Thailand (SET) rule, all listed companies mustbe public limited company. Therefore, they must comply with disclosure requirement of StockExchange in addition to the Public Limited Company Act itself. SET’s regulations on transactionswith related companies are that:

- For low-value transactions, the company must declare the detail of the transaction topublic.

- For high-value transactions, the company must consult with an independent financialconsultant and must get an approval from shareholder meeting.

5.2.2 Group Characteristics

There are 117 groups in the sample. The average number of firms in a group is 5.68 and the medianis 3. A firm is considered being in a group if a controller of the group controls more than 10%of the voting rights of the firm22. The mean and median group age are approximately 30 and 28years, respectively.18Sole proprietor is an individual running his or her own business.19Non-registered partnership is two or more people forming a venture without registration with the Ministry of

Commerce.20For the purpose of this study, private limited company also includes registered partnership (i.e. partnership

registered as a juristic person) as well as liability limited partnership (i.e. a partnership comprising two types ofpartners — limited liability partner and unlimited liability partner) because all of them are governed by the Civil andCommercial Code. A reader should be careful that there are also some legal difference among these firms.21The number in the parenthesis in front of each item indicates the section number.22 In practice, it is difficult to know exactly how many firms are in each group. In this paper, I scope my analysis

on relatively large firms only. Precisely, the number of firms in each group considered here is the number of large

20

Definition and calculation of ultimate ownership and control follow La Porta, Lopez-de-Silanesand Shleifer (1999) and Claessens, Djankov and Lang (2000). In case that there is a chain share-holding, I initially compute the ownership along the chain by calculating the product of share alongthe chain. The calculation is more complicated if there are more than one chain for each firm. Insuch case, the ultimate ownership is the sum of the ownership over all chains that can be tracedback to the controlling family23. Corporate control is based on the voting right the family has.Due to a “one share, one vote” rule, control is just the share the family holds. However, in caseof a chain shareholding, control over the voting right of a firm is the minimum share along eachchain. The ultimate control is the sum of the controls over all chains24. The calculation gets morecomplex when there is a cross shareholding, where I have to calculate ownership (and control) ofmultiple firms simultaneously25. Finally, the group’s average ownership (or control) the average ofthe ownership (or control) over all firms in the group. It is obvious that chain shareholdings createa discrepancy between ownership and control. In this sample, the mean and median of group’saverage ownership are 54% and 53%, respectively. They are 58% and 57% for group’s averagecontrol.

Not every groups have member firms registered as public limited company or listed company inthe stock market. On average, 29% of firms in a group are listed and 31% are public company.

Some groups also have intermediaries as member firms. In this paper, intermediaries includecommercial bank, finance and security company, insurance company, company offering financialservices (such as credit cards), holding company, and venture capitalist. However, more than halfof groups do not have these kinds of firm as a member.

To measure industry homogeneity, I compute two indices: one for a broad classification ofindustry, and the other one for a detailed classification. The indices are in the range of zeroand one, where one represents a perfect homogeneity and zero implies perfect diversity26. Thehigher the index, the more homogenous is the group in terms of industry classification. Industryhomogeneity index I is based on a broad classification of industry while index II is on a moredetailed classification. The mean and median index across groups are 0.68 and 0.58, respectively,for the broad classification. They are 0.41 and 0.35, respectively, for the detailed classification.Table 3 presents summary statistics of the group characteristics.

firms in the group. See Samphantharak (2002) for more detail.23Consider figure 1B as an example. In this case, the families own 51.12% of Peace Canning (1958) Co. Ltd.;

9.71 + (0.1091 ∗ 51.12) = 15.40% of Pattaya Food Industries Co. Ltd.; and 0.2066 ∗ 15.40 = 3.18% of Royal CanIndustries Co. Ltd.24Consider figure 1B again. The families control 52.12% of voting rights in Peace Canning (1958) Co. Ltd.;

9.71+min{52.12, 10.91} = 20.62% in Pattaya Food Industries Co. Ltd.; and min{20.62, 20.66} = 20.62% in RoyalCan Industries Co. Ltd.25Consider figure 1D. Suppose that the family owns x% of Vee Rubber Co. Ltd. and y% of Vee Rubber International

Co. Ltd. We must have that x = 11.98+ 0.875 ∗ y and that y = 75+ 0.25 ∗ x. Solving these equations simultanouslygives us x = 99.33 and y = 99.83. In general, this is a fixed-point problem with discount factors less than one.Therefore, the solutions always exist.

26The index for group I is·MIPm=1

³nm,I

NI

´2¸ 12, where NI is the number of firms in group I, nm,I is the number of

firms in group I that are in industry m, and MI is the number of industries in group I.

21

Table 3 Summary Statistics for Group Characteristics No. of

Groups Mean Median Min Max Std.

Dev. Number of Firms 117 5.68 3 2 51 7.71 Age (1996) 117 30.05 28 7 114 16.51 Average Ownership 117 0.54 0.53 0.06 1 25.77 Average Control 117 0.58 0.57 0.15 1 23.40 Number of Listed Firms 117 1.54 1 0 18 2.62 Fraction of Listed Firms 117 0.29 0.25 0 1 0.31 Number of Public Firms 117 1.63 1 0 19 2.68 Fraction of Public Firms 117 0.31 0.25 0 1 0.32 Number of Financial Intermediaries 117 0.41 0 0 15 1.74 Fraction of Financial Intermediaries 117 0.04 0 0 0.57 0.12 Number of (Broad) Industry 117 2.09 2 1 6 1.31 Index of Industry Homogeneity I 117 0.68 0.58 0.18 1 0.29 Number of (Detailed) Industry 117 2.87 2 1 19 2.72 Index of Industry Homogeneity II 117 0.41 0.35 0.01 1 0.35

6 Empirical Results

The main problem of estimating equation (8) is that it is very unlikely that QMPKi,t is correctlymeasured, especially for non-listed firms that we do not have “market” variables such as stockprices. Also, it is unclear what the empirical counterpart for QFINi,t is27. In this paper, I usethe average Tobin’s Q as proxied by a ratio of market to book values as a measure of firm’sfundamental profitability, QMPKi,t , and firm’s cash flow as a proxy fort QFINi,t . The reasons for thischoice of variables are as follows: First, there are a lot of studies on investment-cash flow sensitivityin the literature. By using the same variables, I can compare my results to theirs. Second, thereis no obvious evidence that other measure of QMPKi,t is significantly better. Third, as Kaplan andZingales (1997) show, if external finance is costly, then investment is positively correlated with cashflow — which is one kind of internal funds of the firm. Finally, from personal conversations withcredit officers in commercial banks in Thailand, I learn that banks pay a lot of attention to cashflow and interest coverage when they evaluate loan applications28.

One of the main problems to get a market to book value as a proxy of QMPKi,t is that thesample consists of both listed and non-listed firms. Since non-listed firms are not traded in thestock market, we do not observe the price variables of the firms and therefore cannot computethe market to book values as usual. To overcome this problem, I compute the industry averagebook to market value and use it as a proxy for firm’s fundamental profitability for all firms in the27To deal with this problem, Gilchrist and Himmelberg (1998) estimate QMPK

i,t and QFINi,t from vector autoregressionmethod introduced by Abel-Blanchard (1988).28Other factors are three-year profits, irregular change in income and cost of production, and credit score. Credit

score is computed from 5-year performance, interest coverage, debt-to-equity ratio, ratio of net worth to paid-upcapital, and qualitative criteria (such as previous records at the bank, parent company, industry situation, andwhether the firm is in the top of its industry).

22

industry. As some listed firms are in business group and their stock price could incorporate thisfact in addition to the profitability information, I use only data on non-group listed firms when Icompute the industry average market to book values29.

To distinguish the result from this paper to the method commonly used in business groupstudies, I compare the results with Hoshi, Kashyap, Scharfstein (1991) approach. In their approach,group firms are less financially constrained so their investment should be less sensitive to their cashflow. The sample in this paper delivers a similar result, as shown in table 4.

Table 4 Regressions of Investment on Cash Flow and Q for Non-Group Firms and Group Firms

Dependent Variable: Investment/Capital (1) (2) Cash Flow/Capital 0.124*** 0.412*** (0.015) (0.033) Group vs. Non-Group Dummy * (Cash Flow/Capital) -0.350*** (0.037) Group vs. Non-Group Dummy Not Included Included Industry Average Q 0.012 0.012* (0.078) (0.007) Adjusted R² 0.022 0.115

Remarks: All regressions include firm fixed effects, firm size, and year effects. Standard errors are in parentheses. ***, **, and * indicate that the estimate is significant at 1%, 5%, and 10%, respectively.

Table 4 shows that, on average, group firms’ investment is less sensitive to cash flow as comparedto non-group firm. This result is consistent to what many studies have found in other samples.However, this approach is criticized by Kaplan and Zingales (1997) as I described in the relatedliterature section.

Instead, the model in this paper suggests that a firm’s investment should be less sensitive tothe firm’s own cash flow, once controlled for the individual group-year effects. Table 5 presents theresult from this regression.29There is an exception when all listed firms in the industry are group firms. In this case, the industry average is

the average over all firms in the industry.

23

Table 5 Regressions of Investment on Cash Flow and Q for Non-Group Firms and Group Firms (Controlled for Each Individual Group-Year Effects)

Dependent Variable: Full Sample Investment/Capital (1) Cash Flow/Capital 0.410*** (0.036) Group vs. Non-Group Dummy * (Cash Flow/Capital) -0.344** (0.040) Individual Group-Year Dummies Included Industry Average Q 0.024*** (0.098) R² 0.021


The result shows that, once group-year effects are controlled, being a group firm decreasesthe investment-cash flow sensitivity from 0.41 by 0.34 on average. The net effect of cash flow oninvestment for group firms is 0.066 and is significantly different from zero at 1% level. This resultimplies either that cash flow may contain some information about firm’s profitability that is notcaptured by industry average Q, firm fixed effects, and year effects; or that there are imperfectinternal capital markets.

If the internal capital markets are not perfect and do not deliver an efficient resource allocationoutcome, it is natural to look next at the factors that facilitate or prohibit the operation of internalcapital markets. I consider five factors in this paper: corporate ownership and control, corporatelaw and regulation, within-group intermediaries, industry diversification, and group size.

6.1 The Effects of Group Characteristics

6.1.1 Corporate Ownership and Control

If the controlling shareholder of a group has more control over the group, it is easier for her totransfer funds across member firms or manage the terms of contract of the loans between the firmswithin the group. Therefore, the group is more likely to have efficient resource allocation outcome.The effect of ownership and control on investment’s response to cash flow is presented in table 6.The sample includes only group firms.

24

Table 6 Effects of Ownership and Control of Group Controlling Shareholders on Investment - Cash Flow Sensitivity of Group Firms

Dependent Variable: Investment/Capital (1) (2) Cash Flow/Capital 0.120*** 0.131*** (0.035) (0.042) Group’s Average Ownership * (Cash Flow/Capital) -0.106* (0.061) Group’s Average Control * (Cash Flow/Capital) -0.115* (0.069) Industry Average Q 0.053*** 0.053*** (0.015) (0.015) Individual Group-Year Dummies Included Included R² 0.167 0.166

Remarks: All regressions include firm fixed effects, firm size, and year effects. Standard errors are in parentheses. ***, **, and * indicate that the estimate is significant at 1%, 5%, and 10%, respectively. Average ownership and control are in scale of 0 to 1.

The coefficient of the interaction term between cash flow and group’s average control is negative.This suggests that the more the control the group controlling shareholder has, the more efficientresource allocation within group30. Back-of-envelope calculation implies that a 10% increase in agroup’s average control reduces the sensitivity of firm’s investment to its own cash flow from 0.131to 0.1195, or approximately 8.78%. The result is similar when I use group’s average ownershipinstead of control.

6.1.2 Corporate Law and Regulation

Table 7 shows the effects of the Public Limited Company Act B.E.2535 and the Stock Marketof Thailand’s regulations on the sensitivity of investment to cash flow. The sample includes onlygroup firms. Since the Public Limited Company Act and the Stock Market of Thailand’s regulationsimpose restrictions on transfers and lending to affiliated firms as well as directors and employees, itis less likely that a group with a big fraction of firms being registered as public company or beinglisted in the stock market will have an efficient resource allocation.30Recall that efficient resource allocation is defined as efficiency in a view of the controlling shareholders.

25

Table 7 Effects of Corporate Law and Regulation on Investment - Cash Flow Sensitivity of Group Firms Dependent Variable: Investment/Capital (1) (2) (3) Cash Flow/Capital 0.031 0.031 0.030 (0.030) (0.031) (0.030) Group’s Fraction of Listed Firms * (Cash Flow/Capital) 0.235* 0.242* (0.144) (0.157) Group’s Fraction of Public Firms * (Cash Flow/Capital) 0.230* (0.142) Group’s Fraction of Non-Listed Public Firms * (Cash Flow/Capital) -0.493 (3.945) Individual Group-Year Dummies Included Included Included Industry Average Q 0.053*** 0.053*** 0.053*** (0.015) (0.015) (0.015) R² 0.166 0.166 0.166 Remarks: All regressions include firm fixed effects, firm size, and year effects. Standard errors are in parentheses. ***, **, and * indicate that the estimate is significant at 1%, 5%, and 10%, respectively.

Regression (1) shows that if all firms in a group are listed, then the sensitivity of investmentto cash flow of a firm in the group will be approximately 0.23 higher than that of a group with nofirms listed. More dramatically, the investment-cash flow sensitivity for a firm in a group that hasno firm listed is basically not significantly different from zero. The effect of the Public CompanyAct is similar and is shown in regression (2).

Since all listed firms must be registered as public company, we can test whether the resultsdescribed above come from being listed or being public company. This can be done by puttingthe interaction term of cash flow and group’s fraction of listed firms together with the interactionterm of cash flow and group’s fraction of non-listed public firms. The predictions are that (a.) ifbeing public company matters, the coefficient of the latter interaction term should be positivelysignificant; (b.) if being public company does not matter, the coefficient of the second interactionterm should not be significant; and (c.) if being listed is different from only being public company,the coefficient of the first interaction term should be significantly more than the coefficient of thesecond interaction term. Regression (3) suggests that being public company does not seem toprevent the existence of internal capital markets. Therefore, the result delivered by regression (2)just comes from the fact that all listed firms must be registered as public company, and many publiccompany are listed in the stock market. This results shed some light on the effectiveness of the

26

Public Company Act B.E.253531.

6.1.3 Within-Group Intermediaries

If intermediaries help facilitate flow of funds across group firms, then groups with intermediariesshould have more efficient resource allocation. Table 8 shows the effects of within-group interme-diaries on firm’s investment-cash flow sensitivity32. The sample includes only group firms.

Table 8 Effects of Within-Group Financial Intermediaries on Investment - Cash Flow Sensitivity of Group Firms

Dependent Variable: Investment/Capital (1) (2) Cash Flow/Capital 0.073*** 0.075*** (0.020) (0.021) Group’s Fraction of Intermediaries * (Cash Flow/Capital) -0.077*** (0.031) Dummy of Having Within-Group Intermediaries * (Cash Flow/Capital) -0.041 (0.054) Industry Average Q 0.052*** 0.053*** (0.015) (0.015) Individual Group-Year Dummies Included Included R² 0.176 0.160


Regression (1) shows that the higher the fraction of within-group intermediaries, the lower thesensitivity of investment to firm’s own cash flow. Roughly speaking, a 10% increase in the fractionof intermediaries reduces the sensitivity from 0.073 to 0.0653, or approximately 10%. However, theresult is not robust when I use dummy of having within-group intermediaries instead of the fractionof intermediaries in the interaction term.31There are few amendments to the Public Company Act B.E.2535 (A.D.1992) after the 1997 economic crisis. One

of the interesting features is that it allows minority share holders to sell their shares back to the company if they thinkthat they are treated unfairly. This amendment is designed in order to give more protection to minority shareholders.Other features include the debt-to-equity swap, which facilitates the debt restructuring process. The amendmentsbecame effective in 2001.32 In this paper, intermediaries include financial intermediaries (commercial banks, finance companies, insurance

companies, companies offering financial services such as credit cards), firms that act as the vertex of the pyramidalstructure of the groups such as holding companies, as well as venture capitalist.

27

6.1.4 Industry Diversification

Table 9 shows the effects of industry diversification on the investment-cash flow sensitivity of groupfirms. The sample includes only group firms. Industry homogeneity indices are in the range of0 and 1. The lower the index, the more diverse is the group in terms of industry. Industryhomogeneity index I is based on a broad classification of industry while index II is on a moredetailed classification.

Table 9 Effects of Group’s Industry Diversification on Investment - Cash Flow Sensitivity of Group Firms

Dependent Variable: Investment/Capital (1) (2) Cash Flow/Capital 0.101** 0.089*** (0.043) (0.027) Group’s Industry Homogeneity Index I * (Cash Flow/Capital) -0.055 (0.066) Group’s Industry Homogeneity Index II * (Cash Flow/Capital) -0.103 (0.099) Industry Average Q 0.052*** 0.052*** (0.015) (0.015) Individual Group-Year Dummies Included Included R² 0.155 0.156

Remarks: All regressions include firm fixed effects, firm size, and year effects. Standard errors are in parentheses. ***, **, and * indicate that the estimate is significant at 1%, 5%, and 10%, respectively. Industry homogeneity indices are in the range of 0 and 1. The lower the index, the more diverse is the group in terms of industry. Industry homogeneity index I is based on a broad classification of industry while index II is on a more detailed classification. The broad classification consists of 8 industries. The detailed classification has 41 industries.

The results show that industry diversification does not affect the investment-cash flow sensitivityof group firms. In other words, the more diversified groups do not tend to have either more or lessefficient resource allocation.

6.1.5 Group Size and Scale Effect

So far we consider only the characteristics that are scale free. All of them are normalized by thesize of the groups. Table 10 shows the effects of group size, as measured by the number of memberfirms, on the sensitivity of the firm’s investment to its own cash flow. The sample in this tableincludes both group and non-group firms.

28

Table 10 Effects of Group Size and Composition on Investment - Cash Flow Sensitivity of Group Firms

Dependent Variable: Investment/Capital (1) (2) (3) (4) Cash Flow/Capital 0.176*** 0.222*** 0.309*** 0.341*** (0.023) (0.026) (0.034) 0.038 Group’s Number of Firms * (Cash Flow/Capital) -0.004** -0.055*** -0.035*** -0.041*** (0.002) (0.015) (0.010) (0.011) Group’s Number of Industries * (Cash Flow/Capital) 0.003 -0.023 -0.016 (0.003) (0.017) (0.017) Group’s Number of Listed Firms * (Cash Flow/Capital) 0.092*** 0.081*** (0.024) (0.025) Group’s Number of Within-Group Intermediaries * (Cash Flow/Capital) -0.047* (0.026) Individual Group-Year Dummies Included Included Included Included Industry Average Q 0.024** 0.025** 0.026*** 0.025** (0.010) (0.010) (0.010) (0.010) R² 0.138 0.155 0.171 0.175


The effect of the number of member firms on the investment-cash flow sensitivity if negativelysignificant. This result suggests that the larger the group, the more efficient resource allocation. Inother words, the result supports the idea that the larger network create more channels of resourcetransfers. This effect overcome the coordination problem that might increase as the group growsbigger.

The effect of group size is robust when I add the number of industries, the number of listedfirms, and the number of within-group intermediaries into the regressions. The effects of industrydiversification, law and regulation, and intermediaries are consistent with the results previouslydescribed. However, the effect of intermediaries seems weaker. The interaction coefficient is nolonger significant at 5%, although it is still significant at 10%.

6.2 Channels of Resource Allocation

[To Be Added]

29

7 Conclusion

This paper tries to answer some questions about business groups: Do business groups really haveinternal capital markets? Do they provide efficient resource allocation (in a view of the controllingshareholders)? What are the characteristics that determine the tendency to have efficient resourceallocation in business groups? This study consider an economy that external capital market isimperfect and external fund is more costly than internal finance, with is natural in emergingeconomies, where capital market is not fully developed and firms tend to have credit constraints.In this environment, the marginal cost of external fund determines the firm’s discount factor that isused in discounting the stream of marginal future benefits of the current investment. As a result, thefirm’s investment will depend on its financial determinants as well as its fundamental profitability.Since a group with absolute control can freely transfer resources across its member firms, theefficient allocation in a view of a controller implies that the marginal costs of fund are equalizedacross firms within the group; therefore, a group firm’s investment should depend only on its group’sfinancial factor and the firm’s own profitability— but not the firm’s financial determinants.

Using this model, I derive an empirical regression counterpart and use it to test the existence ofinternal capital markets in business groups. I also test various characteristics of groups that tendto affect the groups’ resource allocation. Firm-level data from Thailand’s Ministry of Commerceis used as a sample in the empirical sections. The results show that corporate control, groupsize, and within-group intermediaries tend to facilitate the efficient resource allocation. Corporatelaws and regulations deliver the opposite results while industry diversification shows no effect onwithin-group resource allocation.

There are some issues that are not considered in detail in this paper. First, group formation andgroup characteristics are exogenously given in this paper. Second, the paper is also abstract fromwelfare analysis of the non-controlling shareholders. These issues are important and are waitingfor further research. However, the results from this paper should shed some light on the nature ofbusiness groups and their structure, which could serve as a starting point to explain why and howbusiness groups are formed.

The main contributions of this paper come in two folds. First, it presents a structural modelwith an empirical counterpart that can be used to study investment behavior of firms in businessgroups. Second, the paper provides empirical evidence from micro data that the structure ofbusiness groups and corporate governance are indeed related to the investment decision of firms.

8 Appendix: Derivation of Equation (6)

I follow the method used by Gilchrist and Himmelberg (1998). Denote ρi = βi (1− δi) and

Λi,t,t+s =sQk=1

³1+λi,t+k1+λi,t+k−1

´, we have

1 + c (Ii,t,Ki,t) = βi

∞Xs=1

ρs−1i Et [Λi,t,t+sMPKi,t+s] .

Using a first-order Taylor approximation around Et [Λi,t,t+s] ' κ1 and Et [MPKi,t+s] ' κ2,

Λi,t,t+sMPKi,t+s ' κ0 + κ1Λi,t,t+s + κ2MPKi,t,t+s. (9)

30

Next, we approximate

Λi,t,t+s =sYk=1

µ1 + λi,t+k1 + λi,t+k−1

¶

Λi,t,t+s =sYk=1

µ1 +

(1 + λi,t+k)− (1 + λi,t+k−1)1 + λi,t+k−1

¶

Λi,t,t+s ' 1 +sXk=1

λi,t+k − λi,t+k−11 + λi,t+k−1

Λi,t,t+s '½

φ0 + φ1FINi,t+k, if firm i is non-group firmφ0 + φJ2FIN

Jt+k, if firm i is in group J ,

(10)

where we assume that λi,t+k−λi,t+k−11+λi,t+k−1 of firm i linearly depends on firm’s financial characteristics33

FINi,t+k and a group-time financial determinant FINJt+k, where J is a group index. The two

extreme cases presented in the previous section can be viewed as special cases to this approximation.For non-group firms, Λi,t,t+s depends only on individual firm’s characteristics. On the other hand,Λi,t,t+s for a firm in a fully controlled group I should depend only on its group-time effect.

Finally, substituting equation (9) into (5), we have


∞Xs=1

ρs−1i Et [Λi,t,t+sMPKi,t+s]


∞Xs=1

ρs−1i Et [κ0 + κ1Λi,t,t+s + κ2MPKi,t,t+s]

1 + c (Ii,t,Ki,t) = κ0βi

∞Xs=1

ρs−1i + κ1βiEt

" ∞Xs=1

ρs−1i Λi,t,t+s

#+ κ2βiEt

" ∞Xs=1

ρs−1i MPKi,t,t+s

#.(11)

33 In theory, this term could depend on any characteristics that determine the cost of external funds. However,financial situation of a firm is one of the most important factors since the data in the firm’s balance sheet and incomestatement, to a big extent, provide information about the default risk of the firm.

31

Then, substitute (10) into (11)

1 + c (Ii,t,Ki,t) = κ0βi

∞Xs=1

ρs−1i + κ1βiEt

" ∞Xs=1

ρs−1i Λi,t,t+s

#+ κ2βiEt

" ∞Xs=1

ρs−1i MPKi,t,t+s

#

1 + c (Ii,t,Ki,t) =

κ0βi∞Ps=1

ρs−1i + κ1βiEt

· ∞Ps=1

ρs−1i (φ0 + φ1FINi,t+k)

¸+ κ2βiEt

· ∞Ps=1

ρs−1i MPKi,t,t+s

¸if firm i is non-group firm

κ0βi∞Ps=1

ρs−1i + κ1βiEt

· ∞Ps=1

ρs−1i

¡φ0 + φJ2FIN

Jt+k

¢¸+ κ2βiEt

· ∞Ps=1

ρs−1i MPKi,t,t+s

¸if firm i is in group J

1 + c (Ii,t,Ki,t) =

(κ0 + κ1φ0)βi∞Ps=1

ρs−1i + κ1φ1βiEt

· ∞Ps=1

sPk=1

ρs−1i FINi,t+k

¸+ κ2βiEt

· ∞Ps=1

ρs−1i MPKi,t,t+s

¸if firm i is non-group firm

(κ0 + κ1φ0)βi∞Ps=1

ρs−1i + κ1φJ2βiEt

· ∞Ps=1

sPk=1

ρs−1i FINJt+k

¸+ κ2βiEt

· ∞Ps=1

ρs−1i MPKi,t,t+s

¸if firm i is in group J

1 + c (Ii,t,Ki,t) =

˜fi +

˜α1Q

FINi,t +

˜α3Q

MPKi,t , if firm i is non-group firm

˜fi +

˜αJ

2QFIN,Jt +

˜α3Q

MPKi,t , if firm i is in group J .

(12)

If the adjustment cost is quadratic in Ii,tKi,t

, then its marginal cost is linear in Ii,tKi,t

. Equation (12)can be rewritten as

Ii,tKi,t

=

(α0 + fi + α1Q

FINi,t + α3Q

MPKi,t + εi,t, if firm i is non-group firm

α0 + fi + αJ2QFIN,Jt + α3Q

MPKi,t + εi,t, if firm i is in group J ,

(13)

where QFINi,t is the present value of financial characteristic that determine the marginal cost of

external finance of firm i; QFIN,Jt is the present value of financial characteristic that determine themarginal cost of external finance of member firms in group J ; and QMPKi,t is the present value of themarginal profitability of investment of firm i in period t. Finally, εi,t is the stochastic componentof the adjustment costs and other stochastic factors that are not captured by QFINi,t , QFIN,Jt , andQMPKi,t .

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